The IRC defines capital assets in a negative sense, stating only that
capital assets are property held by the taxpayer, whether or not
connected with his or her trade or business except for certain items.
The list of non-capital assets is as follows:

1. Property that is inventory or held primarily for sale by the
taxpayer to customers in the ordinary course of trade or business.

2. Depreciable property or land used in a trade or business.

3. A copyright; a literary, musical, or artistic composition; a letter
of memorandum, or similar property, if held by a) a taxpayer whose
personal efforts created such property, b) in the case of a letter,
memorandum, or similar property, a taxpayer for whom such property was
prepared or produced, or c) a taxpayer in whose hands the basis of such
property is determined, for purposes of determing gain from a sale or
exchange, in whole or in part, by reference to the basis of such
property in the hands of a taxpayer described in (a) or (b) (e.g., a
nontaxable exchange).

4. Accounts or notes receivable acquired in the ordinary course of
doing business.

5. Certain U.S. government publications.

Of these exclusions, the first has been subject to the most
interpretation, especially with respect to the definition of
"primarily." The various courts have been undecided as to whether
"primarily" meant mainly or merely substantially. The Supreme Court in
Malat v. Riddell (1966) helped to remove the uncertainty by holding that
"primarily" for purposes of Sec. 1221 means the same as it does for
everyday usage, namely "of first importance" or "principally."

The regulations add little to the definition. They do make it plain
that depreciable property not used in a trade or business may qualify as
a capital asset. They also expand somewhat the definition of "similar
property."

THE CORN PRODUCTS CASE

Taxpayers, of course, wish for a narrow view of capital assets when
they incur losses and a broad definition when they have gains.
Conversely, the IRS prefers a broad definition of capital assets in loss
transactions and a narrow definition when gains are realized by
taxpayers. Thus, neither side will be completely happy, no matter how
the Supreme Court and the lower courts define capital assets. In Corn
Products Refining Co., the company wanted to treat income realized from
hedging in commodity futures as capital gains. However, in ruling
against the taxpayer, the Court said, ". . . the definition of a capital
asset must be narrowly applied and its exclusions interpreted broadly."
The court considered this necessary because "the preferential treatment
provided capital assets . . . applies to transactions which are not the
normal source of business income." The specific result of Corn Products
was to deny preferential treatment to gains from hedging transactions.
However, as will be discussed later, Corn Products was also cited to
permit ordinary loss deductions where the IRS asserted that a loss
should be a capital loss.

THE ARKANSAS BEST CASE

In Arkansas Best, a bank holding company had purchased additional
stock in a bank, not for investment purposes, but for the business
purpose of protecting the company's reputation by preventing the bank's
failure. In seeking ordinary loss deduction for its losses on the sale
of such stock, the company argued that the term "property held by the
taxpayer, whether or not connected with his trade or business" does not
include property that is acquired and held for a business purpose,
asserting in effect that the asset's status as "property" turned on the
motivation behind the decision. However, the court held that the
taxpayer's motivation in purchasing an asset is irrelevant to the
question of whether it falls within the broad defintion of capital
assets, and that the judicial application of Corn Products to analyze
motive was an unwarranted expansion of Corn Products.

Hence, the court opted for a broad definition of capital assets as
opposed to its definition in Corn Products and considered the five
exclusions from capital assets in Sec. 1221 to be exhaustive rather than
illustrative. The court did state that in applying some of the
exceptions, a "close connection" between an option and inventory might
be sufficient to treat the option as a surrogate for inventory and thus
be eligible for ordinary gain/loss treatment.

The court somewhat disingenuously said that this decision was not
inconsistent with Corn Products, stating that Corn Products applied only
to commodity hedges. In fact, the court in Corn Products said that the
definition of capital assets must be defined narrowly, while in Arkansas
Best the court defined capital assets in a broad sense. The Corn
Products did not just apply to commodity hedges is amply illustrated by
the plethora of cases unrelated to commodity futures that have cited
Corn Products. A later section of this article contains a discussion of
cases that would likely have been decided differently with Arkansas Best
as a precedent.

APPLYING ARKANSAS BEST TO

OTHER CASES

As might be expected, a number of court cases subsequent to Arkansas
Best have cited the case. In Barnes Group, Inc. (1988) the company had
entered into a foreign currency contract to offset a contract to sell.
The purpose of the contract was to offset losses it expected from its
ownership of a Swedish company due to expected currency devaluations.
The company sought to deduct the losses as ordinary and cited as
precedent a tax court case, Hoover Co. v. Comr., 72 TC 206 (1979), which
had similar facts. The district court however, said that Hoover must be
reexamined in light of Arkansas Best.

In Buthcher (1989) the U.S. Bankruptcy Court held that a banker's
investment in stock was a capital asset, not a business asset, and,
therefore, interest and other expenses were investment expenses. The
banker who controlled and operated several banks asserted that he was in
the business of banking and, therefore, the bank stock was a business
asset. In rejecting this argument, the court cited Arkansas Best. In
Olson (1989) the Tax Court found that the sale of stock in financial
institutions, even though deemed an integral part of taxpayer's
business, did not fit any of the narrow--post-Arkansas Best--exclusions
from capital asset treatment. The stock was not inventory, nor was it
held for sale in the taxpayer's business, nor was it subject to wear and
tear, exhaustion, or obsolescence. Note how this contrast with previous
cases decided under Corn Products such as Hagan (1963) where the
taxpayer, a salesman, purchased stock in a corporation, and, as part of
the purchase agreement, received exclusive sales rights to certain of
the corporation's products. When the corporation became insolvent, an
ordinary loss deduction was allowed by the court, because of the
business intent shown by Hagan in purchasing the stock.

The potential wide-sweeping effect of Arkansas Best is illustrated in
the Azur Nut Company case. As a precondition to accepting an executive
position with the company, the individual demanded and was given
protection against a possible loss on the sale of his house.
Eventually, the executive was terminated and the company realized a loss
of $111,366 on the sale of his house; the company purchased the house
from the executive for an agreed upon price of $285,000. Although the
company advanced several arguments to buttress its position that the
loss was ordinary rather than capital, the argument related to Arkansas
Best was that the house purchase satisfied a business need and that it
was therefore deductible in full as an ordinary and necessary business
expense. The Tax Court however, citing Arkansas Best, said that the
motive of the taxpayer was not relevant in determining the status of the
taxpayer. Since the asset was not "used in" the trade or business,
(although its purchase was connected with the trade or business), it was
a capital asset. The Fifth Circuit, in affirming the decision, said
that the phrase "used in a trade or business," which, if applicable,
would exclude capital asset treatment if the assert were also
depreciable, does not suggest that an asset may be excepted from capital
asset treatment simply because the asset is acquired with a business
purpose. Ratheer, the asset must be actually used in the taxpayer's
business. Therefore, if the asset has no meaningful association to the
taxpayer's business, it does not meet the "used in" test.

This case will probably discourage companies from directly purchasing
houses of executives. In the future, a guarantee against loss will
likely be structured in other ways.

FUTURE IMPACT OF

ARKANSAS BEST

A number of court cases cited Corn Products in deciding that a given
transaction generated ordinary income or loss. If these cases were
decided today, a much different decision might be rendered. In Campbell
Taggart (1984), a holding company whose subsidiaries were engaged in the
manufacture of food products took an ordinary loss deduction for the
sale of stock in a Spanish supermarket chain. The Fifth Circuit held
thqat the holding company had a business motive in purchasing the stock,
and that under Corn Products the loss was ordinary. This case would
surely be decided differently today. In Becker-Warburg Paribas (1981) a
brokerage firm was allowed to deduct as an ordinary loss the sale of a
seat on the New York Exchange because the purpose of the acquisition was
to enhance its business. Under Arkansas Best the existence of a
business purpose would not affect the decision as to whether the stock
exchange seat was a capital asset. In Union Pacific (1975) the Court of
Claims held that the railroad's holding in a subsidiary was for business
purposes and was, therefore, not a capital asset. In Electrical
Fittings (1960) the taxpayer, a manufacturer of electrical conduit
fittings, joined with three other parties to build a foundry to produce
iron castings, its supply of castings had been unreliable. Relying on
Corn Products, the Tax Court held that the taxpayer held stock in the
foundry only to obtain an adequate supply; hence, this was a business,
not an investment, motive and the loss on the sale of the stock was
ordinary. The Court of Claims ruled similarly in Booth Newspapers
(1962).

Under Corn Products, securities in many instances, in addition to
those cited, were held not to be capital assets when the intent of
purchasing was business rather than investment. By ruling in Arkansas
Best that intent is not relevant, the Supreme Court appears to have
placed stock and securities firmly within the capital asset definition,
regardless of the motivation in acquiring those securities.

HOW WILL THE QUESTIONS

BE ANSWERED?

Although Arkansas Best has, by affirming up the definition of capital
asset, removed much of the latitude for judicial interpretation in this
area, many questions remains. Will the courts be symmetric in applying
Arkansas Best, i.e, will they be as likely to interpret the exclusion
narrowly in the case of gains as losses? Will any exceptions to capital
asset treatment for stock or securities be granted by the courts after
Arkansas Best, e.g., critical supply needs of the business? Will the
stricter and narrower construction of exclusions from capital asset
treatment affect the definition of property? The courts have sometimes
denied capital asset treatment to taxpayers on the grounds that the
transaction did not involved the sale of "property." For example, money
received to indemnify for the invasion of privacy--e.g., the sale of
rights to a life story--has been held not to be property.

Will the courts be more likely to treat these items as the sale of
property, thus qualifying for capital gains?

To some extent, Congress is to blame for the confusion. As mentioned,
Sec. 1221 contains no positive definition of capital assets, only a list
of what capital assets are not. With only a negative definition, there
is no conceptual foundation upon which to build well-reasoned
administrative and judicial decisions. Taxpayers would be well served
if Congress rewrote Sec. 1221 to describe what a capital asset is as
well what it is not. Perhaps Congress should also consider expanding
the definition of Sec. 1231 assets. The harsh restrictions on capital
loss deductions appear unfair when applied to the disposition of
business assets. It is not readily apparent why the sale of some
business assets should yield unrestricted deductions--Sec. 1231 losses--
when the sale of other business assets should, in the absence of capital
gains, result only in a loss carryforward. The whole area of capital
and Sec. 1231 assets should be reexamined.

RECENT DEVELOPMENTS--THE

CIRCLE K CASE

Recall that in Arkansas Best, the Supreme Court said that the
motivation in purchasing an asset is irrelevant to the question of
whether it falls under the definition of a capital asset. Thus, the
Court of Claims decision on Circle K Corporation in 1991, at first
glance, appears very surprising. In Circle K, the company, a
convenience store chain that also sold gasoline, was experiencing
difficulty in obtaining adequate supplies of gasoline. Therefore, the
company purchased about 12% of the stock in NuCorp Energy, Inc., an oil
company. Circle K also entered into an exploration and development
agreement under which it would acquire a 10% operating interest in all
future oil and gas exploration and development activities of NuCorp.

The next year, Circle K turned back all interest in drill sites and
leases to NuCorp in exchange for additional stock. As part of the
agreement, Circle K received an option to purchase crude oil from
NuCorp. Circle K never actually used the option, and later NuCorp ran
into financial difficulties, eventually filing Chapter 11
reorganization. Subsequently, Circle K sold the stock at a sizeable
loss, and deducted the loss as ordinary. After the IRS, on audit,
recategorized the ordinary loss deduction as a capital loss, Circle K
was denied a claim for a refund. It then sued for the refund in the
Court of Claims. The Court of Claims, while recognizing that the
Supreme Court in Arkansas Best widened the definition of a capital
asset, noted that the Supreme Court continued to uphold Corn Products
with respect to hedging transactions, i.e., continued to permit ordinary
loss deductions for hedging transactions. The Claims Court noted that
the "source of supply principle"--situations where corporate stock is
purchased by the company in order to obtain access to raw materials--was
not directly addressed by Arkansas Best and, thus, may still be valid.
Therefore, if a source of supply stock purchase has a "substantially
close connection" to the business so as to be an integral part of the
inventory-purchase system, the transaction would qualify as a hedging
transaction. In holding for Circle K, the Claims Court held that the
investment in and agreement with NuCorp did have a substantially close
connection to the business to qualify under the inventory exception.
The Claims Court so ruled despite the fact that no inventory transaction
ever took place.

HAVE THINGS REALLY

CHANGED?

What are the implications of Circle K? Does it represent a step back
to the body of cases that extended Corn Products to analyzing the motive
of transactions? Or, does it merely represent an extension of the
application of the rules for hedging transactions? The second
implication appears more likely. It is doubtful that in such previously
discussed cases as Olson, Butcher, or Azur Nut Co., that the Circle K
case would be of much help in claiming ordinary asset treatment.
However, though the Supreme Court reduced Corn Products down to a
beachhead, the Court of Claims has slightly widened that beachhead.
Interested parties should stay tuned for future developments.

Gary L. Maydew, PhD, CPA, is an Associate Professor of Accounting at
Iowa State University. He is the author of a book on agribusiness
accounting and taxation and has a forthcoming book on tax planning for
small businesses. Dr. Maydew has published articles in Taxes, The CPA
Journal, The National Public Accountant, and other journals, and
regularly conducts seminars on taxation and accountancy topics.

The
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